The Court reversed (6-2) the Third Circuit ruling and held that bankruptcy courts may not approve structured dismissals that provide for distributions that do not conform to the ordinary priority rules, even as a “rare case” exception.

To briefly revisit the facts, the debtor was a financially-troubled trucking company. A private equity firm acquired the company in a leveraged buy-out and refinanced the company’s debt. Shortly thereafter, the company defaulted on these obligations and filed a Chapter 11 bankruptcy petition.

The company terminated most of its employees, including its truck drivers, just one day before filing the petition, which gave rise to a multimillion dollar priority wage claim. Despite the truckers’ priority status, distributions to the company’s senior lenders would have drained the company’s limited coffers, leaving nothing for the truckers.

At the same time, the unsecured creditors’ committee pursued fraudulent transfer claims against the senior lenders. Eventually, the senior lenders and the committee entered into a settlement agreement that would shuffle a few million dollars to the general unsecured creditors, thus bypassing the truckers’ priority claims. The bankruptcy court approved the settlement over the truckers’ objection and the district court affirmed that decision.

In a “close call,” the Third Circuit upheld the lower courts’ decisions, but stressed that deviation from the statutory priority scheme should occur only in those rare circumstances when bankruptcy courts “have specific and credible grounds to justify deviation.” Much of the Third Circuit’s reasoning attached to the simple fact that – whether the settlement was allowed or disallowed – the truckers would, in the court’s estimation, walk away empty-handed.

The Supreme Court disagreed. As Justice Breyer explained for the majority, the bankruptcy court cannot disregard the statutory priority scheme, at least not in the context of a structured dismissal.

A distribution scheme ordered in connection with the dismissal of a Chapter 11 case cannot, without the consent of the affected parties, deviate from the basic rules that apply under the primary mechanisms the Code establishes for final distributions of estate value in business bankruptcies.”

In reaching its conclusion, the Court reinforced that the priority rules are “a basic underpinning of business bankruptcy law” and “fundamental.” Admittedly, the structured dismissal statute gives bankruptcy courts a limited authorization to alter the status quo ante “for cause.” The Court ruled that flexibility does not extend to non-consensual modifications of the priority rules. Indeed, the Court suggested, departures from the status quo should only be permitted insofar as they are designed to protect third parties who reasonably relied on any modifications made throughout the course of the bankruptcy proceedings.

A dissent (authored by Justice Thomas and joined by Justice Alito) did not take aim at the majority’s reasoning but, instead, took umbrage with a perceived bait-and-switch. In Justice Thomas’ view, the Court granting certiorari on a particular question – whether a bankruptcy court may authorize the distribution of settlement proceeds in a manner that violates the statutory priority scheme – but that the truckers argued and the majority answered the related but narrower question of whether a Chapter 11 case may be terminated by a structured dismissal that distributes estate property in violation of the priority scheme.

The dissent underscores an important take-away. The Court’s determination that bankruptcy courts may not depart from the statutory priority scheme, even in rare circumstances, applies only to cases concluding with a structured dismissal. The practice of a secured creditor bypassing an intervening class and “gifting” proceeds to a lower class of creditors in other situations (e.g. plan confirmations, liquidations) remains a fair and fertile battleground.

In an earlier blog piece we reported on the Third Circuit’s 2015 decision in In re Jevic Holding Corp. where the Court approved a settlement, implemented through a structured dismissal, which allowed junior creditors to receive a distribution prior to senior creditors being paid in full. The decision was appealed and the Supreme Court agreed to hear the case and decide whether structured dismissals are permissible in bankruptcy. More to come…

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